Evolving Thoughts on Inflation

In early 2005, Greenspan said that the fact that long-term rates were lower despite the Fed’s campaign to raise
short-term rates was a “conundrum.” 
Many rushed to offer
the Fed Chair an explanation of the conundrum, which given past cycles may not
have been such an enigma in the first place.  

Be it as it may, at last week’s
press conference, Yellen admitted that the decline in inflation was a “mystery.”
  She said, “I
can’t say I can easily point to sufficient set of factors that explain this
year why inflation has been as low.”

However mysterious the decline in inflation is, Yellen does not appear
to be embracing a structural view that has been
by some of Fed officials, such as Governor Brainard.
Yellen insists that transitory factors are behind the decline in inflation
and that they will diminish over time.   She still sounds confident
that over time, as slack in the labor market
is absorbed, wages will rise, and businesses can be expected to pass on higher
costs to consumers.  

Yellen is interested in a very narrow issue.  The core PCE
deflator rose from 1.25% in July 2015 to nearly 2% in H2 16 and has
subsequently fallen to 1.4%. This is
Yellen’s focus.  As core inflation firmed, the Fed was feeling more
confident about removing some accommodation.  By June, opinion
frayed.   The decline in inflation
become more concerning for more Fed officials.

Many have offered to resolve Yellen’s mystery.  They cite
structural factors, like globalization, demographics, and technological
disruptions.  The arguments are fine and good
but are beside the point.  These structural arguments do not explain the recent decline: why the core PCE deflator
stood near 1.8% last July and only 1.4% this past July (the most recent
reading, until the August report on September 29).  It is not very
satisfying to receive a long-term structural explanation for a short-term

Some economists have taken a look at the basket of goods and services and
found that air travel, apparel, and used
car prices have dragged the core measure lower. 
  The appropriate
level of analysis is not the integration of China and the former Soviet Union
into the market economy.  It is not about the Baby Boomers retiring, or
unfolding of Moore’s Law.  

The chief economist at the BIS, Borio offered his take in a speech last
  He focused on the factors that seemed to have broken down the
old relationship between economic activity and prices.  Borio offers a
clear and compelling explanation:  Globalization.   The
establishment of global value chains and the entry of low-cost producers and their
cheap labor into the market economy is at the center of his

The Financial Times’ Davies see Bario at odds with Yellen. 
Davies makes it sound that protocol prevented Bario from criticizing Yellen
directly for not accepting the structural arguments.  But we suggest Bario
and Yellen are looking at different things.  Bario is looking at the
long-term decline interest rates and inflation.  Yellen is looking at the
last several months.  

Moreover, the agreement between Yellen and Bario is of greater
The policy prescription is the same, though they arrive at it
somewhat differently.  Yellen argues that the transitory nature of
inflation depressants suggest the Fed should look past them and maintain its
course of gradually removing accommodation. 

Bario argues that the disinflationary forces, emanating from
globalization and technological advances are benign.
  Officials should
accept greater deviation from their point targets of inflation and allow
greater time to reach the targets.  In the meantime,
Bario argues central banks should put more weight on financial
stability.    Ironically, and Davies sees this, the immediate
policy prescription of Yellen and Bario is the same.   Continue to
raise rates gradually.  

In fairness, in recent speeches and
FOMC minutes, it seemed to us that the Fed’s leadership was placing more
emphasis on financial conditions.
  The FOMC upgraded its concern about
asset prices in July.  However, at last week’s press conference, Yellen’s
defense of the financial stability mandate was not as robust as it had
been.  It was somewhat disappointing.  We suspect it is a question of emphasis.    We will
look closely at how financial conditions are
, if at all, in today’s speech.  

We are struck by the fact that BOE
Governor Carney has since he took the job hinted at the need to raise rates
nearly every year but last year when they were
Once again, he
suggested it was possible, and again the
markets ran with it, driving up UK rates
and sterling.  In contrast, the Fed said last week that it might raise rates three times next year, and
the market yawned.  Oh, it moved to upgrade the risks of a December
hike,  The December 2018 contract implies a 1.50% effective Fed funds rate
then.  The effective average now is 1.16%.  A December 2017 hike
should bring the effective rate to 1.41%.  

In early phases of the recovery, we were skeptical of claims that the Fed
lost credibility, but now it seems palpable.
  The Fed, in effect, has
said, that in its judgment, the US economy needs less accommodation. 
Investors have voted with their pocketbooks, and by driving dollar and interest
rates lower and equities higher, they have eased financial conditions. 
There is a tension here that if the Fed were to fold its cards and capitulate to the market’s judgment,
it would be more difficult to rebuild
that credibility.  


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